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Passing the Buck

It's impossible not to notice the weakness in the U.S. dollar in recent years. News reports regularly herald the dollar's decline against the Euro and other major currencies. Travel to cities like London, Paris or Montreal has become more and more expensive. And the prices of imported luxury goods such as French wine or Italian designer clothing have increased substantially.

Will the dollar ever return to previous levels? Or will the popular budget travel book have to be renamed Europe on $1,000 a Day? L. Josh Bivens PhD, an economist with the Economic Policy Institute in Washington, D.C., says today's dollar is closer to where it should be than it was four or five years ago. "Between 1997 and 2002 there was an extraordinary run-up in the dollar's value, beginning with the Asian currency crisis when investors took their money out of those economies and invested in the dollar," Bivens asserts.

What causes the dollar to move? The overarching answer is foreign demand driven by two distinct groups. If private investors are bullish on U.S. stocks and bonds, they demand dollars to make those investments, driving up the currency's value. When investors decide U.S markets are no longer the place to be, the dollar falls.

Bivens says there is also a public demand for U.S. dollars. "Many central banks have loaded up on U.S. dollar reserves. China, for example, has accumulated roughly $1 trillion of dollar reserves," he says. Despite China's actions, Kathy Lien, chief currency strategist at FXCM in New York City, says the dollar's status has changed: "The dollar used to be the primary reserve currency. Now that we're confident the Euro is here to stay, central banks and private investors are shifting some of their holdings into Euros."

The dollar moves differently against the currency of countries like China, Malaysia and Taiwan that buy U.S. dollars as a matter of policy, continues Bivens. He says what's happening today is an ongoing correction. "Private investors realize the U.S. stock market is no longer doing better than other markets and are worried the dollar will decline further. So they are pulling back and driving the dollar down."

Bivens adds that the U.S. trade deficit--the excess of imports over exports--is another important factor in the dollar's decline. It peaked in 2006 at about 6 percent of gross domestic product (GDP). "The large deficit is a clear sign the dollar was overvalued." Ideally, he says, we want an exchange rate consistent with a manageable and stable trade deficit, say 3 percent. "For the last five years, U.S. consumers have had it too easy. Imports have been too cheap to sustain a balanced trading relationship. It's a tough correction," he says, "but one that needs to happen."

A weaker dollar is obviously bad for many U.S. consumers. Lien says the declining dollar has significantly decreased our purchasing power abroad. "Everyone feels the pain," she adds. "--especially tourists." People who buy imported goods will also have to either pay more or turn to less expensive domestic alternatives.

For that reason, the weaker dollar is good news for American companies competing against imported goods. Bivens says "as the value of the dollar drops, imported goods are expensive relative to goods produced in the United States--cars made here look more affordable than those made in Germany." Lien says another advantage of the weaker dollar is the potential impact on the housing market. "As the dollar weakens, foreign investors will become more interested in U.S. real estate as prices drop, and they can buy property with cheaper dollars.

What does the declining dollar mean for U.S. investors? Says Bivens: "Future investment strategy should depend on what you think the dollar will do going forward." For example, he says it's inevitable that the Chinese currency will need to gain in value against the dollar. But while it would be great to invest in China to take advantage of that increase, it's not easy for foreigners to invest in the country's economy.

Lien agrees that the weakening dollar means investors should be more selective in their investment choices. "Over the past year, people have become more aware of the impact currency movement can have on investment performance." She says the companies that do well when the dollar is weak are those that export a lot. "Investors should also look at companies with factories in the countries where there is a demand for their products. Their cost of doing business will be lower and earnings hopefully higher," she continues.

Bivens and Lien agree the dollar is about where it should be and won't rise much in the near future. In fact, Lien believes it may get weaker. "More interest rate cuts by the Federal Reserve," she says, "could cause further weakness. But the rate cuts will do their job, and the dollar will bottom out and begin to recover."

Bivens believes the dollar has fallen too much against the Euro and the Canadian dollar. The dollar needs to drop further, he says, against the currency of countries where the central bank is buying dollars. "These countries have managed the value of their currency to keep their exports cheap in the U.S. marketplace."

Peter D. Fleming is a freelance business and investment writer in New York City. He was a Senior Editor of the Journal of Accountancy for 16 years.